You\'ve just taken a job at an investment banking firm and been given the job of

Question

You've just taken a job at an investment banking firm and been given the job of calculating the appropriate nominal interest rate for a number of different Treasury bonds with different maturity dates. The real risk-free interest rate that you have been told to use is 2.5%, and this rate is expected to continue on into the future without any change. Inflation is expected to be constant over the future at a rate of 2.0%. Since these are bonds that are issued by the U.S. Treasury, they do not have any default risk or any liquidity risk (that is, there is no liquidity-risk premium). The maturity-risk premium is dependent upon how many years the bond has to maturity. The maturity-risk premiums are as follows: Given this information, what should the nominal rate of interest on Treasury bonds maturing in 0-1 year, 1-2 years, 2-3 years, and 3-4 years be?

Explanation / Answer

The normal rate of interest = Real risk-free rate + Inflation rate + Default risk premium + Liquidity premium + Maturity risk premium.

As the these securities issued by US Treasury so there is no default risk or any liquidity risk premiums.

So, the normal rate of interest (NRI) = Real risk-free rate + Inflation rate + Maturity risk premium.

NRI(0-1)year = 2.5% + 2% + 0.05% = 4.55%

NRI(1-2)years = 2.5% + 2% + 0.3% = 4.80%

NRI(2-3)years = 2.5% + 2% + 0.6% = 5.10%

NRI(3-4)years = 2.5% + 2% + 0.9% = 5.40%

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